Opinion: New stock market indicator shows 2015 will be profitable

CHAPEL HILL, N.C. (MarketWatch) — Good news, beleaguered equity investors: A new indicator suggests that 2015 will be an above-average year for the stock market.

I know, I know — many of my recent columns have explored several reasons why the coming year could be tough for stocks. But never will it be the case that all evidence points in one direction, and today is no exception.

That’s especially so because a recent academic study has created a new indicator that, according to its authors, has a better track record than 14 others that previous research had identified as showing promise. The study, which has been shared in academic circles for a couple of months, was conducted by two finance professors at Washington University in St. Louis (Matthew Ringgenberg and Guofu Zhou) and an economics professor at St. Louis University (David Rapach).

The new indicator is based on the total amount of short selling in U.S. stocks. (Stock exchanges release information on short selling, which is a way that investors bet on a decline in prices.) Short interest is calculated by comparing the percentage of shares outstanding that’s sold short, or how many days a stock’s trading volume that short interest represents.

Investors often misinterpret short interest. They assume that more shorting is a good thing, on the theory that it represents deferred buying demand for the stock.

But this new study finds strong evidence that, in the aggregate, short sellers actually have more insight than the rest of us.

Translating their insight into a broad market-timing indicator turned out to be tricky, however, since the total volume of short selling has been rising over several decades. The authors of the new study, therefore, calculated an index based on the extent to which any given month’s short-selling activity was above or below trend. It’s this index that they found to have a superior track record forecasting the stock market’s returns over the subsequent 12 months.

Currently, as you can see from the accompanying chart, this new short-interest index is well below its long-term trend — suggesting 2015 will be an above-average year.

Is that the end of this cheerful story? Unfortunately not, since it comes with some crucial qualifications.

The first is that the short-selling community, though generally more insightful than the rest of us, is not infallible. Notice from the accompanying chart that their short-selling activity was below trend even at the top of the Internet bubble — which means many of the short sellers had drunk that era’s Kool-Aid along with everyone else. In their defense, however, Prof. Ringgenberg pointed out in an interview, by March 2001—less than half way into the 1980-1982 bear market, the short sellers as a group had seen the light and were shorting at an above-average pace.

In any case, more often than not over the past four decades, the short sellers have increased their short selling prior to major market declines. They showed impressive prescience leading up to the Great Recession, for example. In fact, the researchers’ Short Interest Index reached an all-time high (i.e., most bearish) in July and August 2007, just two months prior to the beginning of the 2007-2009 bear market.

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Another important qualification is statistical. Consider the R-squared of this new indicator’s track record when forecasting the market’s returns over the subsequent 12 months. R-squared is a statistical measure of how much one data series is correlated with changes in another; a model that had perfect explanatory power would have an R-squared of 100%.

The researchers report an R-squared of 12% for their new index, which means that it explains 12% of the variation in the stock market’s year-ahead returns. In other words, it fails to explain 88% of that variation.

If you find this number depressingly low, welcome to the real world. Most of the models you read or hear about have a vanishingly small R-squared.

Nevertheless, Washington University’s Ringgenberg emphasized, a 12% R-squared is still high enough to enable a disciplined investor to beat the market over the long term.

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